Sometimes, it seems as if the credit rating agencies just can't win. They were criticized after the Enron meltdown for not downgrading the troubled energy merchants quickly enough. Now, some say they are too trigger-happy and are making things difficult for companies trying to strengthen their balance sheets. To combat any misconceptions about how ratings are formed, analysts from Standard & Poor's visited executives with E&P companies that are not currently rated, as well as bankers who advise them, in Houston recently to "demystify" the rating process. Some companies avoid being rated by S&P or the other two agencies-Moody's Investors Service and Fitch Ratings-because they fear they may be saddled with a poor rating that they will never be able to shake. Bruce Schwartz, a director at S&P, assured executives that his firm will upgrade ratings as companies improve. For example, about seven years ago, S&P instituted a four- to five-notch upgrade on virtually the entire contract-drilling sector due to vast improvements in the sector's business outlook, Schwartz said. He added that if current strong cash flows continue, the independent E&P sector may see a similar wave of upgrades to the investment-grade level. The last independent to receive such an upgrade was Ocean Energy Inc. in 2001. What S&P looks for when rating a company is how long it can weather a down cycle in market conditions. Investment-grade companies-those with ratings of BBB or better-can handle at least three years of down-market conditions, Schwartz said. Currently, S&P's E&P universe has an average rating of BB, a non-investment-grade rating. Many independents aim for BBB ratings, but not higher, choosing instead to use strong cash flow to fund future growth. Schwartz expects to see independents use their money in the coming years to buy other companies, rather than buy back their own shares, to build their project inventory. Rising unit costs and a deficit of exploration prospects that are viable at historic prices are among the biggest challenges facing the E&P sector today, the analysts add. They also stressed that they use conservative commodity-price assumptions in their rating models. "We want to change ratings because of management decisions and business execution, not commodity-price movement," Schwartz said. John Whitlock, credit analyst and director, utilities, energy and project finance, emphasized that S&P will never blindside a company with a rating-all issuers know their ratings before the public does, and have the chance to appeal a rating decision and provide additional material information before the rating is published. "We want to be assured that our decisions are based on current, accurate information," Whitlock said. Moody's Investors Service issued a statement: "The financial strength of an E&P company is not completely captured in the financial statements alone." It considers a number of reserve-related metrics and components of the cost structure, along with financials, to understand the strengths and weaknesses of a company. It looks at reserves and production, cost structure and leverage. "The companies face constant pressure to replace production and grow their reserve base," says John Cassidy, Moody's vice president and senior credit officer. "We believe this challenge will become even more difficult, which is why we place a fair amount of emphasis on the need for financial flexibility and a relatively strong balance sheet to be considered an investment-grade company." While independents are having difficulty with consistently replacing production exclusively through the drillbit at competitive costs, Moody's expects further consolidation in the industry, more churning of assets, and an increasing reliance on technology "because large new discoveries in mature basins in North America are not likely to occur." In all, it rates 17 investment-grade E&P companies, most of which have ratings in the Baa category and stable rating outlooks. In total, they have approximately $50 billion in rated debt outstanding. -Jodi Wetuski

Comments